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Small-cap stocks fall into the red for 2017 in latest example of lost faith in the 'Trump trade'

  • The Russell 2000 index, benchmark for small-caps, fell into the red for 2017 on Monday.
  • The demise of small-cap stocks is the latest example of the market starting to lose faith in the Trump trade that drove this year's rally.
  • Jefferies has a 2017 price target of 1,410 on the Russell 2000, implying about a 4 percent gain.
  • Advocates for small-caps see compelling valuations and expectations for rising rates and more U.S. growth boosting the sector.

The demise of small-cap stocks is the latest example of the market starting to lose faith in some of the investing themes that had been driving this year's rally.

As part of the so-called Trump trade, companies at the lower end of the market-cap spectrum were expected to flourish. The idea was that lower corporate tax rates coupled with rising bond yields would drive more investor cash to the small-cap space.

However, neither of those two factors has come to pass. President Donald Trump's tax reform agenda remains stalled in Congress, and bond yields actually have declined since the beginning of the year. Small-caps benefit from lower taxes in the U.S. because they do most of their business domestically, while higher bond yields generally push investors out of larger stocks.

Jefferies equity strategist Steven G. DeSanctis is betting the "small-cap market does not go much higher from here," with the firm sticking to a 1,410 target for the Russell 2000, implying a "low-return environment."

Indeed, the Russell has struggled this year, closing in the red for 2017 on Monday after surging more than 25 percent from shortly before the November presidential election through July 25. The index has seen four consecutive weeks of losses.

At Monday's close, the small-cap benchmark's slight fall on the day pushed it to a 0.03 percent loss for 2017.

Investors have taken notice, pulling billions out of ETFs that track small-cap indexes. For instance, the iShares Russell 2000 fund has seen just shy of $4 billion in redemptions this year, representing about 8 percent of total assets. The fund saw $351 million in outflows on Friday alone.

DeSanctis sees four critical factors at play: a weaker dollar favoring larger companies that do business overseas; margin pressures from higher costs for inputs and wages; big losses especially from the discretionary and energy sectors; and small-caps serving as a "canary in the coal mine" for slower U.S. economic growth.

"The weaker dollar and better global growth favors large over small," DeSanctis said in a note. "This will not reverse itself anytime soon."

How the drop could stop

The expected small-cap rally was part of a larger Trump-inspired equation that also was supposed to see a big year for banks, materials and industrials. Banks were supposed to benefit from higher rates as well as a relaxed regulatory environment, while materials and industrials looked to gain from a surge in infrastructure spending.

All three areas, though, have underperformed the broader market. Large-caps have outperformed as earnings have jumped, but investors have gotten increasingly defensive.

Wall Street, however, has not given up on small-caps. Lori Cavalsina, managing director at Credit Suisse, sees the factors that initially pushed the play coming back into view.

While acknowledging that "the case is not clear-cut," Cavalsina expects the case for rising rates is still solid amid stronger growth later this year, while the slide in the Russell 2000 has made a more compelling valuation argument.

In addition, Credit Suisse is more optimistic on U.S. growth than Jefferies, with GDP projections of 2.3 percent in both 2017 and 2018. The 2 to 3 percent range is the sweet spot for small-caps where they outperform their large-cap counterparts.

And earnings are expected to improve as well, with the firm projecting 13.7 percent growth in 2018 that will outpace large-caps (9.7 percent) and mid-caps (10.6 percent.)

Finally, the firm is making the biggest bet of all — that the Trump trade is not, in fact, dead and will resume and bring small-caps along for the ride.

"The small/large trade has remained closely aligned with public views on Trump," Cavalsina said in a note. "We think small caps are still being treated as a way to express faith in the reflation trade, and that perceptions of Trump continue to be a driver there."

Cavalsina also isn't worried about a pullback, which she said will only make small-cap valuations more compelling. Indeed, Jefferies' muted projections still imply a 4 percent increase in the Russell 2000 from current levels.

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